Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet

8-1McGraw-Hill/IrwinChapter Twenty-TwoManaging Interest Rate Risk and Insolvency Risk on the Balance Sheet22-2McGraw-Hill/IrwinInterest Rate RiskThe asset transformation function performed by financial institutions (FIs) often exposes them to interest rate riskFIs use (at least) two methods to measure interest rate exposurethe repricing model (a.k.a. the funding gap model) examines the impact of interest rate changes on net interest income (NII)the duration model examines the impact of interest rate changes on the overall market value of an FI and thus ultimately on net worth22-3McGraw-Hill/IrwinInterest Rate RiskThe U.S. central bank’s (the Federal Reserve’s) monetary policy is the most direct influence on the level and movement of interest ratesChanges in the Federal Reserve’s fed funds target rate affect all interest rates throughout the economyexpansionary monetary policy involves decreases in the target fed funds ratecontractionary monetary policy involves increases in the target fed funds rate22-4McGraw-Hill/IrwinThe Repricing ModelThe repricing or funding gap is the difference between those assets whose interest rates will be repriced or changed over some future period and liabilities whose interest rates will be repriced or changed over some future periodQuarterly reporting of commercial bank assets and liabilities is detailed by maturity bucket (or bin)one daymore than one day to 3 monthsmore than 3 months to 6 monthsmore than 6 months to 12 monthsmore than 1 year to 5 yearsmore than 5 years22-5McGraw-Hill/IrwinThe Repricing ModelThe gap in each bucket or bin is measured as the difference between the rate-sensitive assets (RSAs) and the rate-sensitive liabilities (RSLs)rate-sensitivity measures the time to repricing of an asset or liabilityThe cumulative gap (CGAP) is the sum of the individual maturity bucket gapsThe cumulative gap effect is the relation between changes in interest rates and changes in net interest income22-6McGraw-Hill/IrwinThe Repricing ModelThe change in net interest income for any given bucket i (ΔNIIi) is measured as: ΔNIIi – (GAPi)ΔRi = (RSAi – RSLi)ΔRiwhere GAPi = the dollar size of the gap between the book value of rate-sensitive assets and rate-sensitive liabilities in maturity bucket i ΔRi = the change in the level of interest rates impacting assets and liabilities in the ith maturity bucket22-7McGraw-Hill/IrwinThe Repricing ModelA common cumulative gap of interest to commercial bank managers is the one-year repricing gap estimate:where ΔNII is the cumulative change in net interest income from all rate-sensitive assets and liabilities that are repriced within a year given a change in interest rates ΔRi22-8McGraw-Hill/IrwinThe Repricing ModelThe spread effect is the effect that a change in the spread between rates on RSAs and RSLs has on net interest income as interest rates change ΔNIIi = (RSAi x ΔRRSA) – (RSLi x ΔRRSL)The repricing model has four major weaknessesit ignores market value effects of interest rate changesit ignores cash flow patterns within a maturity bucketit fails to deal with the problem of rate-insensitive asset and liability runoffs and prepaymentsit ignores cash flows from off-balance-sheet activities22-9McGraw-Hill/IrwinThe Duration ModelDuration measures the interest rate sensitivity of an asset or liability’s value to small changes in interest ratesThe duration gap is a measure of overall interest rate risk exposure for an FITo find the duration of the total portfolio of assets (DA) (or liabilities (DL)) for an FIfirst determine the duration of each asset (or liability) in the portfoliothen calculate the market value weighted average of the duration of the assets (or liabilities) in the portfolio22-10McGraw-Hill/IrwinThe Duration ModelThe change in the market value of the asset portfolio for a change in interest rates is:Similarly, the change in the market value of the liability portfolio for a change in interest rates is:22-11McGraw-Hill/IrwinThe Duration ModelFinally, the change in the market value of equity of a FI given a change in interest rates is determined from the basic balance sheet equation: By substituting and rearranging, the change in net worth is given as:where k is L/A = a measure of the FI’s leverage22-12McGraw-Hill/IrwinThe Duration ModelThe effect of interest rate changes on the market value of equity or net worth of an FI breaks down to three effectsthe leverage adjusted duration gap = (DA – kDL)measured in yearsreflects the duration mismatch on an FI’s balance sheetthe larger the gap the more exposed the FI to interest rate riskthe size of the FIthe size of the interest rate shock22-13McGraw-Hill/Irwin The Duration Model22-14McGraw-Hill/IrwinThe Duration ModelDifficulties emerge when applying the duration model to real-world FI balance sheetsduration matching can be costly as restructuring the balance sheet is time consuming, costly, and generally not desirableimmunization is a dynamic problemduration of assets and liabilities change as they approach maturitythe rate at which the duration of assets and liabilities change may not be the sameduration is not accurate for large interest rate changes unless convexity is modeled into the measureconvexity is the degree of curvature of the price-yield curve around some interest rate level22-15McGraw-Hill/IrwinInsolvency RiskTo ensure survival, an FI manager must protect against the risk of insolvencyThe primary protection against the risk of insolvency is equity capitalcapital is a source of fundscapital is a necessary requirement for growth under existing minimum capital-to-asset ratios set by regulatorsManagers prefer low levels of capital in order to generate higher return on equity (ROE)the moral hazard problem exacerbates this tendencythe result is an increased likelihood of insolvency22-16McGraw-Hill/IrwinInsolvency RiskThe economic meaning of capital is net worthnet worth is equal to the difference between the market value (MV) of an FI’s assets and the market value of its liabilitiesthe market value or mark-to-market value basis uses balance sheet values that reflect current rather than historical pricesRegulatory and accounting-defined capital is based in whole or in part on historical or book values (BV)22-17McGraw-Hill/IrwinInsolvency RiskThe market value of capital and credit riskdeclines in current and expected future cash flows on loans lowers the MV of an FI’s assetsdeclines in the MVs of assets is directly charged against the equity owners’ capital or net worthliability holders are only hurt when asset losses exceed equity capital levelsthus, equity capital acts as “insurance” protecting liability holders (and guarantors such as the FDIC) against insolvency riskThe market value of capital and interest rate riskrising interest rates decrease the value of an FI’s assets more than the value of the FI’s liabilities when the duration gap of the FIs balance sheet is positiveagain, losses are first charged against equity capital22-18McGraw-Hill/IrwinInsolvency RiskThe book value of equity capital is the difference between the BV of assets and the BV of liabilitiesthe BV of equity is usually composed of the par value of equity shares, the surplus value of equity shares, and retained earningsthe BV of equity does not equal the market value of equitymanagers can manipulate the BV of equity byusing discretion when timing the recognition of loan lossesselectively selling assets to inflate reported earnings (and thus capital)22-19McGraw-Hill/IrwinInsolvency RiskInterest rate changes have no impact on book values of assets and liabilitiesFIs can be solvent from a BV perspective, but massively insolvent from an economic perspectiveThe degree to which the BV of equity deviates from the MV of equity depends oninterest rate volatilityexamination and enforcementloan tradingThe discrepancy between the MV and BV of equity is measured by the market-to-book ratio22-20McGraw-Hill/IrwinInsolvency RiskArguments against using market value accounting includeit is difficult to implementespecially so for small FIs that are not publicly tradedit introduces an unnecessary degree of variability into reported earningsFIs may be less willing to accept longer-term asset exposures if they must be continually marked-to-marketlikely would interfere with FIs’ role as lenders and monitors and could lead to a “credit crunch”